Personal Liability Concerns
You may be concerned about personal liability for other legal claims against your business, such as:
? lawsuits over unpaid bills
? contract disputes
? slip-and-fall or other personal injuries that occur on business property
? damage your employees cause to others in the regular course of business, such as automobile accident damage, and
? local, state, and federal assessments of civil fines and penalties for regulatory violations.
A. How Your Choice of Business Entity Affects Personal Liability
Liabilities are debts—money you owe. Every business carries some liabilities—for example, ongoing payments to suppliers, rent for your office, compensation to employees, or fees for contractors. Additional liabilities may arise if your business is devastated by a fire or flood or if you are the victim of a lawsuit—for example, someone is injured in your studio and sues you for damages.
1. Sole Proprietorships and General Partnerships
Sole proprietorships and general partnerships offer no liability protection. If you operate your business as a sole proprietorship—the most common form for businesses—then you will be personally liable for all business debts. The same is true for a partnership. A creditor can collect a partnership debt from any partner, regardless of which partner incurred the debt. That means that if your partner orders $50,000 worth of equipment (without telling you) and then moves to Venezuela, you could be on the hook. A written partnership agreement can apportion liability among partners, but it won't absolve you of personal liability.
2. Limited Liability Entities
Corporations and limited liability corporations (LLCs) (and certain other business forms, such as limited partnerships) shield their owners from personal liability. For a dramatic example of how this shield works to deflect liability, consider the recent demise of a 52-store chain. The company owed millions to suppliers and filed for bankruptcy, but the owners were not personally liable for these debts because they had created a corporate entity that owned the company.
If you operate as a corporation or LLC, creditors can—with some exceptions discussed below—collect their debts only from the business's assets, not from the owners. This means that a person who invests in an LLC, corporation, or limited partnership stands to lose only the amount of money or the value of the property that he or she has paid for its stock. As a result, if the corporation does not succeed and cannot pay its debts or other financial obligations, creditors cannot seize or sell the corporate investor's home, car, or other personal assets.
3. Exceptions to the Rule of Limited Personal Liability
Here are a few of the most common exceptions to the rule of limited personal liability; these exceptions also apply to other limited liability business structures, such as the LLC.
? Personal guarantees. When a bank or other lender lends money to a small corporation, particularly a newly formed one, it often requires the principal corporate owners (shareholders) to agree to repay the loan from their personal assets if the corporation defaults. In some instances, shareholders may even have to pledge equity in a house or other personal assets as security for repayment of the debt.
? Federal and state taxes. If a corporation fails to pay income, payroll, or other taxes, the IRS and the state tax agency are likely to attempt to recover the unpaid taxes from "responsible persons"—a category that often includes the principal directors, officers, and shareholders of a small corporation. The IRS and state sometimes succeed in these tax collection strategies. Therefore, paying taxes should be a top priority for all businesses.
? Unlawful or unauthorized transactions. If you use the corporation as a means to defraud people, or if you intentionally make a reckless decision that results in physical harm to others or their property—for example, you fail to maintain premises or a worksite properly when you've been warned of the probability of imminent clanger to others, or you manufacture products that you know to be unsafe—a court may hold you individually liable for the monetary losses of the people you harm. Lawyers call this "piercing the corporate veil," meaning that the corporate entity is disregarded and the owners are treated just like the owners of an unincorporated business.
Fortunately, most of these problem areas can be avoided by following a few common-sense rules—rules you'll probably adhere to anyway. First, don't do anything dishonest or illegal. Second, make sure your corporation does the same, by obtaining necessary permits, licenses, or clearances for its business operations. Third, pay employee wages and withhold and pay corporate income and payroll taxes on time. Fourth, don't personally obligate yourself for corporate debts unless you decide that the need for corporate funds is worth the personal risk.
Here are some tips that will help you hold on to your limited liability protection:
? Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders. Or, put more bluntly, don't engage in fraud.
? Fund your LLC or corporation adequately. You don't have to invest a lot of money in your LLC or corporation, but do try to start out with enough cash or other liquid assets to meet foreseeable expenses and liabilities. If you fail to do this, a court faced with a balance sheet that shows a very minimal investment may feel that you are playing fast and loose with your finances—and may disregard your limited liability protection if you have not fully disclosed your marginal financial situation to creditors, investors, and other outsiders who have a financial stake in your limited liability entity. This is particularly likely if you engage in a risky business that requires a large investment and you keep your marginal situation a secret.
? Keep corporate/LLC and personal business separate. Nothing will encourage a court to disrespect your limited liability entity faster than your own failure to respect its status as an entity separate from its owners. This means you'll want to immediately get a federal Employer Identification Number and open up a separate business checking account. As a routine business practice, write all checks for business expenses or payouts of profits out of this account, and deposit all business revenue into it. Keep separate accounting books for your business—you can use a simple single entry system, such as your check register and deposit slips, but a double-entry system will serve you better when it comes time to prepare your end-of-year income tax returns, especially if yours is a multimember company. Lastly, you should keep written records of all major business decisions. The best way is to make it a policy to hold corporate and LLC meetings to make all important business decisions, which are documented with written minutes placed in your LLC or corporate records book.
4. Limited Partnerships
A limited partnership (LP) also can be formed under state law, but only the investors in an LP get limited liability protection. The managing partners (there must be at least one in an LP) remain personally liable for business debts. Now that states allow the formation of LLCs, which give all owners—including all managers and investors—limited liability protection, LPs have fallen out of favor with entrepreneurs.
For these reasons, the LLC has become the entity of choice if the owners do not want to form a corporation. Forming an LLC provides a convenient and cheap form of liability insurance for unincorporated businesses—its limited liability protection provides an extra measure of personal liability protection over and above the limits of the business's commercial insurance policy.
B. Using Insurance to Limit Liability
One of the best ways to limit your liability—without limiting your business's potential for growth—is through insurance. Insurance can provide a suitable umbrella when creditor problems rain on your business. Although insurance coverage will add to your ongoing costs, the premiums will be regular and predictable.
If forming a corporation or LLC can limit your liability, why bother with business insurance? Because the corporate or LLC form only protects you when your business goes under—that is, it's an endgame protection. If your business's debts become so burdensome that you must declare bankruptcy, having an LLC or corporate structure will shield you from personal loss. But until you cry "bankruptcy," your business must find a way to pay its debts—which, if you're uninsured, could leave you writing some hefty checks.
Insurance has its drawbacks: periodic payments, annoying deductibles, and policy language that only a lawyer could love. But commercial and workers' compensation insurance is the best way to protect against business disasters such as fire, theft, injury to visitors, workplace injuries, and, if you can afford the extra premiums, injuries resulting from the use of your products or services, and even claims that you injured another business through false advertising. And if you are sued, your insurance policy may help pay not only your damages, but also the cost of hiring a lawyer to defend you (in fact, the insurance company will normally insist that you use their lawyers and agree to follow their advice concerning fighting or settling a lawsuit).
Sometimes your business must get insurance—for example, because state laws require you to obtain workers' compensation coverage, or because you sign a lease requiring you to have business and personal property coverage. In other cases, insurance may prove too expensive and you'll have to forgo it. A good insurance agent can help you make the right decisions about whether you need insurance and what type of coverage makes sense for your business.
Here are some tips on choosing and using your insurance wisely:
? Maintain enough property and liability coverage to protect yourself from common claims—for example, fire, theft, or accidental injury.
? Buy insurance against serious risks—that is, those that would cost you the most if they occurred (as long as the insurance is reasonably priced for your business).
? When possible, keep insurance costs down by selecting high deductibles.
? Do your best to reduce hazards or conditions that can lead to insurance claims.
Most businesses buy several kinds of insurance to protect them from business catastrophes:
? Property insurance covers damage to the space where you do business and to your business equipment—your computers, furnishings, inventory, and supplies. For example, if a fire destroys your studio, the insurance will cover the cost of restoring the studio and replacing your equipment and other tangible assets. Of course, you'll probably have to pay a deductible, and every policy places a cap on the total amount the insurance company will pay out.
? Liability insurance covers claims and lawsuits by people or businesses that have suffered physical or financial losses because of your business activities. This would include, for example, standard "slip-and-fall" coverage that would handle a claim by a delivery person who trips on a cable in your office and breaks an ankle. As with property insurance, there may be a deductible for you to pay, and there will be a cap on your coverage.
? Business interruption insurance covers losses you incur if you must temporarily curtail or cease operation because of a fire or flood. If your business property is damaged or destroyed, and you have to shut down for two months while your premises are rebuilt and your equipment is replaced, you may lose substantial income and have to pay significant expenses in the interim. These losses and expenses are covered by business interruption insurance.
Although your liability insurance may cover business legal disputes like defamation or copyright infringement, the policy language may be too narrow to include claims based on your website activities. Traditional policies lump defamation and copyright infringement claims into a category intended for advertising activities. Having a website may or may not be treated as advertising under your liability policy.
For more Information
* Corporation, Limited Liability Companies, Company Director’s Desktop Guide, Company Secretary’s Desktop Guide, Corporate Records Handbook *
You may be concerned about personal liability for other legal claims against your business, such as:
? lawsuits over unpaid bills
? contract disputes
? slip-and-fall or other personal injuries that occur on business property
? damage your employees cause to others in the regular course of business, such as automobile accident damage, and
? local, state, and federal assessments of civil fines and penalties for regulatory violations.
A. How Your Choice of Business Entity Affects Personal Liability
Liabilities are debts—money you owe. Every business carries some liabilities—for example, ongoing payments to suppliers, rent for your office, compensation to employees, or fees for contractors. Additional liabilities may arise if your business is devastated by a fire or flood or if you are the victim of a lawsuit—for example, someone is injured in your studio and sues you for damages.
1. Sole Proprietorships and General Partnerships
Sole proprietorships and general partnerships offer no liability protection. If you operate your business as a sole proprietorship—the most common form for businesses—then you will be personally liable for all business debts. The same is true for a partnership. A creditor can collect a partnership debt from any partner, regardless of which partner incurred the debt. That means that if your partner orders $50,000 worth of equipment (without telling you) and then moves to Venezuela, you could be on the hook. A written partnership agreement can apportion liability among partners, but it won't absolve you of personal liability.
2. Limited Liability Entities
Corporations and limited liability corporations (LLCs) (and certain other business forms, such as limited partnerships) shield their owners from personal liability. For a dramatic example of how this shield works to deflect liability, consider the recent demise of a 52-store chain. The company owed millions to suppliers and filed for bankruptcy, but the owners were not personally liable for these debts because they had created a corporate entity that owned the company.
If you operate as a corporation or LLC, creditors can—with some exceptions discussed below—collect their debts only from the business's assets, not from the owners. This means that a person who invests in an LLC, corporation, or limited partnership stands to lose only the amount of money or the value of the property that he or she has paid for its stock. As a result, if the corporation does not succeed and cannot pay its debts or other financial obligations, creditors cannot seize or sell the corporate investor's home, car, or other personal assets.
3. Exceptions to the Rule of Limited Personal Liability
Here are a few of the most common exceptions to the rule of limited personal liability; these exceptions also apply to other limited liability business structures, such as the LLC.
? Personal guarantees. When a bank or other lender lends money to a small corporation, particularly a newly formed one, it often requires the principal corporate owners (shareholders) to agree to repay the loan from their personal assets if the corporation defaults. In some instances, shareholders may even have to pledge equity in a house or other personal assets as security for repayment of the debt.
? Federal and state taxes. If a corporation fails to pay income, payroll, or other taxes, the IRS and the state tax agency are likely to attempt to recover the unpaid taxes from "responsible persons"—a category that often includes the principal directors, officers, and shareholders of a small corporation. The IRS and state sometimes succeed in these tax collection strategies. Therefore, paying taxes should be a top priority for all businesses.
? Unlawful or unauthorized transactions. If you use the corporation as a means to defraud people, or if you intentionally make a reckless decision that results in physical harm to others or their property—for example, you fail to maintain premises or a worksite properly when you've been warned of the probability of imminent clanger to others, or you manufacture products that you know to be unsafe—a court may hold you individually liable for the monetary losses of the people you harm. Lawyers call this "piercing the corporate veil," meaning that the corporate entity is disregarded and the owners are treated just like the owners of an unincorporated business.
Fortunately, most of these problem areas can be avoided by following a few common-sense rules—rules you'll probably adhere to anyway. First, don't do anything dishonest or illegal. Second, make sure your corporation does the same, by obtaining necessary permits, licenses, or clearances for its business operations. Third, pay employee wages and withhold and pay corporate income and payroll taxes on time. Fourth, don't personally obligate yourself for corporate debts unless you decide that the need for corporate funds is worth the personal risk.
Here are some tips that will help you hold on to your limited liability protection:
? Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders. Or, put more bluntly, don't engage in fraud.
? Fund your LLC or corporation adequately. You don't have to invest a lot of money in your LLC or corporation, but do try to start out with enough cash or other liquid assets to meet foreseeable expenses and liabilities. If you fail to do this, a court faced with a balance sheet that shows a very minimal investment may feel that you are playing fast and loose with your finances—and may disregard your limited liability protection if you have not fully disclosed your marginal financial situation to creditors, investors, and other outsiders who have a financial stake in your limited liability entity. This is particularly likely if you engage in a risky business that requires a large investment and you keep your marginal situation a secret.
? Keep corporate/LLC and personal business separate. Nothing will encourage a court to disrespect your limited liability entity faster than your own failure to respect its status as an entity separate from its owners. This means you'll want to immediately get a federal Employer Identification Number and open up a separate business checking account. As a routine business practice, write all checks for business expenses or payouts of profits out of this account, and deposit all business revenue into it. Keep separate accounting books for your business—you can use a simple single entry system, such as your check register and deposit slips, but a double-entry system will serve you better when it comes time to prepare your end-of-year income tax returns, especially if yours is a multimember company. Lastly, you should keep written records of all major business decisions. The best way is to make it a policy to hold corporate and LLC meetings to make all important business decisions, which are documented with written minutes placed in your LLC or corporate records book.
4. Limited Partnerships
A limited partnership (LP) also can be formed under state law, but only the investors in an LP get limited liability protection. The managing partners (there must be at least one in an LP) remain personally liable for business debts. Now that states allow the formation of LLCs, which give all owners—including all managers and investors—limited liability protection, LPs have fallen out of favor with entrepreneurs.
For these reasons, the LLC has become the entity of choice if the owners do not want to form a corporation. Forming an LLC provides a convenient and cheap form of liability insurance for unincorporated businesses—its limited liability protection provides an extra measure of personal liability protection over and above the limits of the business's commercial insurance policy.
B. Using Insurance to Limit Liability
One of the best ways to limit your liability—without limiting your business's potential for growth—is through insurance. Insurance can provide a suitable umbrella when creditor problems rain on your business. Although insurance coverage will add to your ongoing costs, the premiums will be regular and predictable.
If forming a corporation or LLC can limit your liability, why bother with business insurance? Because the corporate or LLC form only protects you when your business goes under—that is, it's an endgame protection. If your business's debts become so burdensome that you must declare bankruptcy, having an LLC or corporate structure will shield you from personal loss. But until you cry "bankruptcy," your business must find a way to pay its debts—which, if you're uninsured, could leave you writing some hefty checks.
Insurance has its drawbacks: periodic payments, annoying deductibles, and policy language that only a lawyer could love. But commercial and workers' compensation insurance is the best way to protect against business disasters such as fire, theft, injury to visitors, workplace injuries, and, if you can afford the extra premiums, injuries resulting from the use of your products or services, and even claims that you injured another business through false advertising. And if you are sued, your insurance policy may help pay not only your damages, but also the cost of hiring a lawyer to defend you (in fact, the insurance company will normally insist that you use their lawyers and agree to follow their advice concerning fighting or settling a lawsuit).
Sometimes your business must get insurance—for example, because state laws require you to obtain workers' compensation coverage, or because you sign a lease requiring you to have business and personal property coverage. In other cases, insurance may prove too expensive and you'll have to forgo it. A good insurance agent can help you make the right decisions about whether you need insurance and what type of coverage makes sense for your business.
Here are some tips on choosing and using your insurance wisely:
? Maintain enough property and liability coverage to protect yourself from common claims—for example, fire, theft, or accidental injury.
? Buy insurance against serious risks—that is, those that would cost you the most if they occurred (as long as the insurance is reasonably priced for your business).
? When possible, keep insurance costs down by selecting high deductibles.
? Do your best to reduce hazards or conditions that can lead to insurance claims.
Most businesses buy several kinds of insurance to protect them from business catastrophes:
? Property insurance covers damage to the space where you do business and to your business equipment—your computers, furnishings, inventory, and supplies. For example, if a fire destroys your studio, the insurance will cover the cost of restoring the studio and replacing your equipment and other tangible assets. Of course, you'll probably have to pay a deductible, and every policy places a cap on the total amount the insurance company will pay out.
? Liability insurance covers claims and lawsuits by people or businesses that have suffered physical or financial losses because of your business activities. This would include, for example, standard "slip-and-fall" coverage that would handle a claim by a delivery person who trips on a cable in your office and breaks an ankle. As with property insurance, there may be a deductible for you to pay, and there will be a cap on your coverage.
? Business interruption insurance covers losses you incur if you must temporarily curtail or cease operation because of a fire or flood. If your business property is damaged or destroyed, and you have to shut down for two months while your premises are rebuilt and your equipment is replaced, you may lose substantial income and have to pay significant expenses in the interim. These losses and expenses are covered by business interruption insurance.
Although your liability insurance may cover business legal disputes like defamation or copyright infringement, the policy language may be too narrow to include claims based on your website activities. Traditional policies lump defamation and copyright infringement claims into a category intended for advertising activities. Having a website may or may not be treated as advertising under your liability policy.
For more Information
* Corporation, Limited Liability Companies, Company Director’s Desktop Guide, Company Secretary’s Desktop Guide, Corporate Records Handbook *
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